Good news, bad news: US economy too strong for interest rate cuts

The US economy was expected to cool a bit along with temperatures this winter, but that slow patch is looking more like business as usual.

The housing slump is still serious. Detroit carmakers are still in trouble. But with oil prices dropping since last summer, overall economic activity keeps chugging along even as inflation looks to be easing.

The momentum has spoiled hopes that the Federal Reserve will cut interest rates anytime soon. The Fed is expected to note signs of strength in the economy, and continued vigilance against inflation, when it releases its latest policy statement Wednesday.

"It's a combination of very savvy monetary policy" by the Fed plus lower oil prices and a dip in mortgage rates, says Brian Bethune, an economist at Global Insight, an economic forecasting firm in Waltham, Mass. "You add all that up, it's a pretty good story."

Good enough that some forecasters have been ratcheting up their projections for US growth during 2007 and for the end of last year.

"We are revising our estimate for fourth-quarter growth to 3.3 percent (annual rate) from 2 percent previously," economists at Goldman Sachs, the New York investment firm, wrote after a solid report two weeks ago on sales by America's retailers.

Numbers on gross domestic product (GDP) for the fourth quarter of 2006, which includes holiday spending, are scheduled to be released Wednesday.

Many economists credit the Federal Reserve with having a steady hand on the monetary tiller. But they generally cite energy as been the biggest factor behind the recent economic strengthening.

Even though oil prices have edged up a bit in recent days, prices are well under last year's highs of close to $80 a barrel.

Gasoline prices have fallen from $3 a gallon at the beginning of August to $2.17 last week, according to the Energy Information Administration. Those prices could reverse, of course. That, and the path of the housing market, remain important uncertainties for 2007.

But Mr. Cosgrove sees a benign outlook for energy. Two years of rising oil prices resulted in a response by corporations, consumers, and governments around the world. Many are moving toward substitute fuels – from coal to ethanol. And conservation slowed the growth of oil demand.

"Oil prices will settle out at about $40 a barrel" in today's dollars, Cosgrove predicts. Over the next two or three years, he explains, "market forces will tend to eventually push prices down to their long-term average."

Not everyone expects prices to fall that far. And analysts including Cosgrove say a geopolitical crisis in the Middle East could always push oil back up to $80 a barrel.

But for now, even at this week's price around $55 a barrel, falling fuel prices have played another important role. They have eased concerns that the Fed may not have done enough to control inflation. In turn, that has helped to keep long-term interest rates in check, a boon for people buying houses or refinancing mortgages.

The average interest on a 30-year fixed-rate loan has fallen from 6.76 percent to 6.25 percent since last July, as tracked by Freddie Mac, a government-chartered home finance agency.

That dip has helped ease the strain of the worst housing downturn since the early 1990s. The volume of home sales has plunged and foreclosures have surged. But the trends would be worse if it cost more to take out a loan, or if it were harder for homeowners to refinance adjustable-rate mortgages at a decent price.

This has happened even as the Fed has been holding short-term rates steady for half a year now.

The central bank had raised short-term interest rates from mid-2004 through mid-2006, in an effort to bring monetary policy to a neutral zone, allowing the economy to grow without fueling inflationary pressures through easy credit.

Some analysts say that if the US economy stays on a smooth track, the Fed could continue to hold steady, with a target short-term interest rate of 5.25 percent, for much of this year.

"The Fed will probably be on hold for an extended period of time," says Cosgrove. That kind of low profile is "probably the way the Fed Reserve under ... [Chairman Ben] Bernanke would like to operate."

Some economists still see some recession risk, especially if the housing troubles persist.

And on the inflation front, others remain concerned that the Fed may need to tighten rates further if the economy gets hotter still. Inflation worries could push up long-term interest rates that, despite edging up recently, remain below 5 percent for Treasury bonds.

But for now, the growth scenario is on track. Mr. Bethune of Global Insight says his firm will probably bump up its GDP forecast for this year to about 2.7 percent growth – "very positive news."